Decision tree analysis shows a project to have several possible outcomes the best of which has an NPV of $10M calculated over a five year life. This best case path has an overall probability of occurring of 25%. A real option is available at an initial cost of $750,000 which will add a single $5M cash inflow to this best case path at its end. The option doesn't have a significant effect on the project's risk. The company's cost of capital is 11%. What is the option's value (to the nearest $1,000)?
The probability of best outcome = 25%
Cash flow associated with real option = $5 ...
The solution uses a decision tree analysis to show that a project has several possible outcomes.